Is renewable energy now cheaper than coal? What might this mean for investors?

It has been another captivating week in the Australian energy markets. The closure of the Hazelwood power plant was announced, thermal coal export prices have continued to surge and there has been endless media speculation about Australia’s chief scientist, Alan Finkel’s upcoming energy security review.

As the next round of UN climate change talks (#COP22) kicks off in Morocco we thought it timely to look away from the domestic debates to a global theme that has taken many by surprise – the sudden and dramatic fall in the cost of renewable energy generation.

A quick flick through the International Energy Agency’s (IEA) recent 2016 Renewable Market Report leaves the reader in no doubt that the global energy markets are in a period of significant and unprecedented change. The IEA is expecting the transition to clean energy to accelerate with renewable energy being expected to provide more than 60 percent of the increase in world electricity generation over the medium term.

Despite coal being outpaced by renewable energy the IEA and its private sector forecasting peers also expect thermal coal to make up a significant chunk of new energy generation between now and 2040. The coal sector point to these forecasts to justify new mines and power plants and notes that, regardless of climate change objectives, it will be some time before the world can do without coal’s cheap, predictable energy.

Despite the anticipated growth in thermal coal, investors are becoming more nervous about its future. For government and private investors, the energy market has changed faster than expected, leading them to ponder whether the IEA’s coal forecasts will materialise. For the first time, such anxieties are not based on concerns about the environment and climate change but coal’s ability to compete with cheap renewable energy.

Such worries are becoming harder to ignore – on a levelised cost of energy (LCOE) basis it is now generally accepted that new build solar energy is cheaper than coal in most markets. Newly constructed coal and solar both produce a mega Watt-hour (“MWh”) of electricity for around USD70. Coal is cheap where the resource is close-by but is disadvantaged where fuel is imported or reasonable emissions standards are required of generators. Solar suffers where irradiation levels are low but provides staggeringly cheap electricity in sunnier places. Recent public auctions in northern Chile and the Middle East delivered prices under USD45 per MWh and India and China are boasting numbers at low as USD30 per MWh. Solar energy price declines show no sign of abating: First Solar’s recently announced Series 6 module may reduce the LCOE from solar by up to 10 percent.

The new cost competitiveness of solar has significant implications, particularly in energy-hungry emerging markets. During climate change negotiations these countries put forward compelling arguments for their right to industrialise using ‘least-cost’ electricity, and this may motivate a switch away from coal. In the past month, China’s National Energy Administration announced that 30 coal plants with a combined capacity of 17GW would be stopped mid-construction. Moreover, more than 114GW of planned coal construction has been shelved around the world this year while solar construction has outstripped expectations. By contrast, in 2015 China added close to 50GW of new coal generation which is more generation capacity than Australia’s National Electricity Market.

For emerging economies, the use of renewable energy provides other support for economic development. Many countries with competitive manufacturing sectors have become exporters of wind turbines and solar panels. Further, importing coal requires foreign currency which can create headaches in countries with vulnerable currencies.

Lastly, world coal prices are notoriously volatile and have recently surged after some 5 years of steady decline. By contrast, once a solar plant is built the cost of electricity generation is known for the next 30 years.

Despite these advantages renewable energy has its limitations – solar panels do not produce power at night, wind can be patchy and poorly interconnected regions suffer from supply volatility. Such problems can be managed through better transmission lines, coordinated dispersion of renewable energy, support from more flexible gas generation and rapidly emerging technologies such as battery storage. While not without their wrinkles, batteries look to be going the way of solar with scale manufacturing causing significant cost reductions.

Lastly, the thorny political issues facing the coal sector have not gone away. Investors still fret about ever changing policy preferences for carbon pricing, emissions standards, air quality and water security. Commentators such as Shelagh Whitley at Britain’s Overseas Development Institute have highlighted the size of the subsidies currently provided to the fossil fuel industry that might be withdrawn as citizens look to cleaner alternatives.

Faced with these emerging risks, the coal sector can respond in a number of ways. Investments in more flexible, cleaner, plant can help coal plants prepare for evolving electricity market needs. Such investments will be repaid by extending the life of plants and improving plant efficiency. The fixed and variable costs of miners and generators will continue to be a major focus if cost reductions are going to keep pace with falls in renewable energy pricing. Coal supply contracts will need to be renegotiated to provide more flexibility for generators who have less certainty over when they will produce electricity.

Investors in new build coal plants face some significant challenges over the short to medium term. Uncertainty abounds but it may be the free market rather than the environmentalist who leads the next phase of the energy revolution.